Uncertainty paralyzes U.S. banking system

November 28, 2008

John Kemp Great Debate– John Kemp is a Reuters columnist. The opinions expressed are his own –

Extreme uncertainty about the economic outlook and the depth of the recession has paralyzed normal lending activity by commercial banks in the United States and elsewhere. Even as the Federal Reserve has added liquidity and boosted bank reserves, the credit creation process has remained stalled as banks struggle to identify good borrowers willing and able to repay in a wide range of future economic conditions.

The attached chart is adapted from the Federal Reserve’s weekly H.8 release on “Assets and Liabilities of Commercial Banks in the United States” (https://customers.reuters.com/d/graphics/US_CRDT1108.gif).

It shows the ratio of loans, leases and interbank lending (risk assets) to vault cash, reserves and Treasury securities (safe assets) held by U.S. commercial banks. In essence it shows the commercial banking system’s appetite for risk and capacity for credit creation.

Credit is clearly cyclical. But the period since 1994 has witnessed a huge increase in credit extension and a massive rise in balance sheet risk overlaid with modest cyclical variations. Following a brief hiatus during the downturn of 2001-2003, explosive credit creation resumed and hit new heights in early 2008.

The ratio of loans, leases and interbank loans to vault cash, reserves and holdings of Treasury securities has increased from 2.4 in April 1994 to 3.2 in Apr 2004 and a staggering 5.3 in Apr 2008.
Since the onset of the crisis, the lending ratio has plummeted to 3.5. It is the sharpest reversal in balance sheet composition since the 1930s.

In fact, commercial bank lending has increased slightly since the onset of the crisis. Increased loans and leases have offset a downturn in interbank activity. Some of this reflects the reclassification of investment banks as commercial ones.

The rest was probably “involuntary” lending as corporations unable to access other forms of credit drew down standby committed lines.

But the massive expansion of Fed lending facilities has boosted commercial bank assets by $500 billion since the end of August. All this additional money has been placed on deposit with the Fed or invested in Treasury securities (+$701 billion) more than offsetting the flight from other loans and securities (-$200 billion).

The credit crunch has manifested itself in an extreme preference for low-yielding but ultra-safe assets.
The massive cushion of cash and cash-like assets held by the commercial banks has dispelled any residual doubts about their short-term liquidity, as it was designed to do.

But by shifting their balance sheets in this way, the commercial banks have essentially blocked the monetary transmission line from the Fed to the rest of the economy, ensuring that monetary easing has not filtered through to Main Street, and forcing the Fed to turn to more unconventional measures to get credit through to the economy.

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